This Is What’s Going On In The Stock Market & What Will Happen Next

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February 12, 2018

This Is What’s Going On In The Stock Market & What Will Happen Next

I’ll tell you exactly what you need to know to make investing decisions now.

The key things to watch are yields, both from stocks and Treasuries.

No matter where you are, the long term picture makes decision making pretty easy.

Introduction

Stocks were down 5% at the beginning of last week which is good news for all of us who keep adding money to our portfolios. It’s not such good news for those who need to sell stocks or need money soon.

The total decline is now 10% and we can officially call it a correction, but that’s short term thinking. What I want to discuss is long term which I think will give you the best base for decision-making.

Let’s first look at the global equities market capitalization for the past 15 years. You can see below that the recent market rout just corrected the extreme run-up we’ve had in the last few months, so practically nothing has happened.

This reminds me of the loss aversion experiment with Capuchin monkeys where one monkey was given one apple while the other received two and had one immediately removed. The first was happy while the second was extremely angry even though the net gain was equal. So don’t be a Capuchin monkey and understand that what has happened was just a correction of past paper gains.

Paper gains is something I want to focus on. The global market cap has increased from $30 trillion in 2003 to $80 trillion today, and close to $90 trillion just two weeks ago.

Did the global GDP level almost triple in the last 15 years? The answer is yes and no. If you look at global GDP measured in constant 2010 dollars, GDP is up 48% in the last 15 years.

However, if we look at the same data in non-inflation adjusted dollars, the global GDP did indeed increase almost 3 times. As stocks should offer some kind of protection against inflation and correlate to economic growth, it’s logical to see stocks up too.

All looks fine, right? Not so fast. I’ll now show you the most important charts for long term investors which are valuations. Further, the above global market cap chart starts in 2002 which was the bottom of the previous bear market where there was a 50% decline.

If we take a look at earnings, not adjusted for inflation, they’ve gone practically nowhere in the last 10 years and are up just 52% since 2000.

Figure 5: S&P 500 earnings since 2000 are cumulatively up just 52% over the last 18 years. Source: Multpl.

As stocks have gone up, earnings have remained flat. The earnings yield, which is the key for long term investors, has just gone down.

The earnings yield compared to the 10-years Treasury yield is what you have to watch when investing. As stocks are far riskier than Treasuries, they command a premium. As the Treasury yield goes up, so should the yield for stocks and therefore stock valuations should drop as it’s better to hold a 10-year Treasury with a yield of 3% than stocks that yield 4%. That spread between stocks and treasuries has never been so narrow in the last 10 years as it is now which simply tells you stocks are overvalued.

As there is a global feeling that interest rates will rise, the markets expect three FED rate hikes in 2018, if not 4. Treasury yields are going to rise and this will inevitably bring stocks down, it’s as simple as that.

The other scenario is that the economy slows down, and central banks keep rates low. But an economic slowdown would have a negative impact on earnings and therefore also push stocks down.

So I don’t know whether stocks will go up or down in the long term, but for the past two years I have been saying how stocks are risky. I’ve been wrong for most of that time as stocks have kept going up, but I know the day of reckoning will come as it always does. The most logical prediction for what will happen next is that interest rates will rise, stocks will fall until higher interest rates don’t slow down the global economy when both interest rates and stocks fall.

Conclusion

I’ll finish with valuations. The cyclically adjusted S&P 500 price to earnings ratio is at the second highest level in history. The likelihood for positive long term returns is minimal.

You may want to take advantage of the still high stock prices and look for protection in bonds with a relatively small part of your portfolio in stocks invested in specific companies that will do well no matter what happens. We’ll discuss such stocks in the future, so keep reading Investiv Daily.